In recent years, the tax framework for nonqualified executive benefit programs has become more complex and expensive to administer. In the split dollar world, there are final regulations and related guidance that must be navigated. In the deferred compensation arena, there is new Internal Revenue Code section 409A, with final regulations and other recent guidance contributing to taxation and administrative challenges.
During this same time, the taxation of executive bonus plans has remained relatively stable. Double bonus plans, where the employer provides both the savings contribution and a grossed-up bonus for income tax costs, remain an attractive option.
However, these plans may not meet a business owner’s need to retain an executive with a strong ‘handcuff.’ For the business to deduct the bonus, it can’t possess any financial interest in the life insurance policy purchased with the bonus.
As nonqualified executive benefit planners, we need to help clients find their way through the maze of tax rules and regulations. Planners should use their knowledge and insight to find the simplest and most cost-effective solutions that meet a business owner’s needs for a nonqualified executive benefit program.
With that goal in mind, new plan types will undoubtedly be created that aspire to provide a meaningful benefit, while successfully navigating the complex regulatory and taxation environment. One such opportunity exists with the short-term deferral exception to the definition of deferred compensation under IRC section 409A found in the final regulations.
Generally, the short-term deferral exception provides that if a benefit is paid in full to an executive within two-and-a-half months after the close of the tax year in which the executive becomes entitled, then compliance with the remaining rules of section 409A is not necessary. For this exception to work, the benefit must be subject to a substantial risk of forfeiture until it is vested.
The exception applied
Let’s look at a specific plan design example that fits within this exception. If an employer has an executive he or she wants to ‘lock-up’ for the next 10 years, and is willing to finance a solution, the employer may offer a nonqualified benefit program with the following simplified plan design. If the executive is still employed with the firm in 10 years, the employer will pay the executive a lump sum of $250,000 no later than 30 days following completion of the 10-year period. It may be easiest to think of this plan as a deferred executive bonus with a very strong handcuff.